Skeptics Abound on Microsoft Deal

The market really doesn't like Microsoft's (MSFT) deal to buy Nokia's (NOK) phone handset business (and non-exclusive, 10-year licenses to Nokia's patents) for $7.2 billion. On Sept. 3, the day of the announcement, Microsoft shares tumbled 4.55%. The next day, Sept. 4, Microsoft dropped another 2.21% as of late afternoon trading.

How bad is this deal? I understand the market's skepticism -- after all Microsoft isn't exactly a nimble innovator. But I believe there are more positive things to be said in favor of the deal than what the market's reaction suggests.

Let's start with the reasons to be skeptical. Microsoft has just bought a phone business that is in free fall and is burning cash. Nokia owned the biggest share of the phone market until 2012, when it was caught by Samsung. Nokia's market share is now down to 14% vs. Samsung's 26%. Also, in developing countries, Nokia's sales of lower-end feature phones are under relentless attack from cheaper phones made in those economies.

Meanwhile, Nokia's smartphones running Microsoft's Windows Phone operating system have garnered just a 3%-to-4% market share. The lack of top-end sales and the erosion of feature-phone sales produced a cash-flow loss at Nokia in 2011 as earnings before interest and taxes came to negative $1.07 billion. That figure deepened to $2.3 billion in 2012.

Microsoft will have to come up with hot products that generate consumer excitement to turn that around -- not exactly a company strong point. The firm also will have to convince more developers to write apps for the Windows Phone operating system. They will also have to somehow manage a workforce of 32,000 in Finland without driving the best talent to flee in frustration with Microsoft's often stifling corporate culture.

Is that a daunting task? You bet. Is Wall Street right to be skeptical? Absolutely. But this deal is a long way from crazy.

First, Microsoft is getting Nokia's handset business for a bargain price. Microsoft is paying only 0.35x annual revenue for these assets. That's less than the 0.77x revenue Google (GOOG) paid for Motorola Mobility. And Microsoft will pay for the deal using cash from the $70 billion horde that it has sitting offshore. Bringing that cash back to the U.S. -- to pay out a special dividend to shareholders, for example -- would generate a big tax hit. So this actually a good use of cash.

Second, while catching Apple (AAPL) and Samsung in the smartphone market seems just about impossible, Microsoft doesn't need an impossible increase in sales in order to break even on this deal. According to Microsoft, increasing Nokia's smartphone sales to an annual run rate of 50 million units from the current 30 million would do the trick. Microsoft believes that will be possible by 2015.

Helping out will be an increase in the profit margin that Microsoft gets on each sale -- from $10 a phone under its current contract with Nokia, to $40 per unit after the deal.

The big unknown is how much money Microsoft will have to spend on marketing the phone to wireless network operators, and to the developers that write apps. This could be the element that can make all those other projections useless.

Initial thinking had operators such as AT&T (T) and Verizon (VZ) leaping into action to make Nokia's new Lumia phones a success, because these operators wanted another alternative to the Android and Apple platforms. That turned out to be overly optimistic. I think there's still good will with wireless operators. However, in order to get AT&T and Verizon to sell these phones in the U.S. market, Microsoft is going to have to spend more than what Nokia had originally assumed.

It's possible, though, that the biggest challenge won't be in building an attractive consumer product or getting display space at AT&T and Verizon. Rather, it could be in closing the huge app gap. In comparison to the 850,000 apps available for Apple's operating system, Windows Phone offers just 160,000. The current download rate for Windows Phone apps is 200,000 million a month. For Apple, the comparable figure is 2 billion. For the Android operating system, it's 2.5 billion a month.

Because of that gap, developers write their apps for Android and Apple first -- and only then turn to Windows Phone, if they do at all. That's fixable with enough cash in payments to developers, but the full cost of this kind of marketing isn't included in Microsoft's projections on how many smartphones it needs to sell in order to break even.

Third, I'd emphasize that Microsoft deserves more credit than it's getting from Wall Street. The company is recognizing that the decline of growth in the personal-computer sector means it has to do something transformative if it's to avoid becoming an irrelevant manager of the Office and Windows software cash cows.

The jury is still very much out on whether the company's efforts in cloud computing, tablets and smartphones are enough to transform the company. Certainly, the company needs a new CEO that can more effectively push new products against entrenched Office and Windows managers. But the price that Microsoft paid is certainly not very high if you think of it as admission to a game it has to play.